​​​
  1. What India needs to do now to reduce imperfections in the economy

What India needs to do now to reduce imperfections in the economy

Given the lack of evidence of supply shocks, the current decline in growth can be attributed to the adverse demand shock, associated with the two major policies of demonetisation and the introduction of GST.

Updated: October 17, 2017 4:23 AM
The recent Reserve Bank of India (RBI) report that cut India’s growth forecast for this fiscal to 6.7% from the earlier projection of 7.3% raised many eyebrows over the country’s future growth potential.

The recent Reserve Bank of India (RBI) report that cut India’s growth forecast for this fiscal to 6.7% from the earlier projection of 7.3% raised many eyebrows over the country’s future growth potential. As part of the recovery efforts, the government cut the goods and services tax (GST) rate on as many as 27 items—including on khakhra and stationary items—and provided some relief to the exporters in terms of tax refund. However, the question is, are these policies adequate for economic recovery considering the current weak domestic and global demand? The decline in GDP growth to 5.7% in the first quarter of this financial year cannot be read in isolation. The growth rate declined consecutively during the last five quarters—from 7.6% in the Q1 of FY16. Here, one must note that the average growth rate during the FY05 to FY15 period was around 7.8%. Hence, the recent growth rate figure indicates that the economy has deviated from its growth trajectory.

In fact, any reduction of growth from its path can be due to either demand or supply shock. Given the lack of evidence of supply shocks, the current decline in growth can be attributed to the adverse demand shock, associated with the two major policies of demonetisation and the introduction of GST. These two policies were expected to have an ameliorating effect on the economy, but the pain of these two shocks still persist in the economy and that contracts the economic activities. The demonetisation ended with a sudden drop in overall transaction in the economy and the consequent decline in demand. Besides, the hike in the oil prices not only increased living cost, but the production cost too. As a result, the overall investment rate in the economy has declined to 29.1% in the Q1 of FY17—from its average rate of 36% (during the FY11 to FY15 period). This decline in investment rate indeed culminated with the decline in GDP growth.

The introduction of GST further depresses the demand, as it increased prices of many goods since most of the producers were unaware of the input credit mechanism that underlies in the GST system. In such a situation, to consider the decline in GDP to be a temporary phenomenon—and to expect the economy to automatically adjust to the higher economic growth path—would be an unrealistic solution, and even the economy may slip into recession. The plummeting investment rate in the economy is a clear indication of diffidence among private enterprises, as the decline in growth primarily reflected in the manufacturing sector. In these circumstances, the government has to take the lead to boost the demand through instruments such as the fiscal stimulus package, which includes high public spending on infrastructure, healthcare and education, among others. In fact, such expenditures help stimulate the demand and facilitate a sustained growth. In addition, inclusion of oil products under GST would be an immediate stimulator. As the economy recovers, the burden on fiscal deficit will also be mitigated with higher tax collection, given the current GST mechanism.

In addition, given the high inflationary pressure, a loose monetary policy may not be a viable option, but certainly can be used as a complementary policy to the fiscal package. Last but not the least, more reforms are required—including land and labour market reforms—to reduce the imperfections and inflexibilities in the economy. These reforms will not only help to reduce the short-term pain of future economic policies similar to GST, but also reduce the distance from short-term to long-term.

KP Prabheesh
Assistant professor, Department of Liberal Arts, IIT Hyderabad.
Views are personal

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

  1. No Comments.

Go to Top